Home Equity Loan vs Refinancing

A home equity loan allows home owners to borrow specific amounts based on the existing home equity. Refinancing a home entails adjusting the terms of the existing home equity in order to get a lower rate. Both of these options have advantages and disadvantages, and which one is best depends mainly on the purpose behind applying for them.

Reasons for Refinancing

Refinancing your home equity can be beneficial when you have a longer history of payments, which may allow you to achieve lower rates. A good rule of thumb to determine if refinancing is the better option is to examine your existing mortgage interest rate. If this rate is higher than 8 to 8.5 percent on a 30-year mortgage, there is a better chance of getting a more desirable rate through refinancing. The possibility of this increases with a good credit rating and a lower debt to income ratio. In this case, home owners who refinance can end up with both lower monthly mortgage payments and lower interest rates than they had previously. Refinancing is the most practical option to help lower high interest rates on existing monthly mortgage payments.

On the down side of refinancing, there are extra requirements if the amount borrowed is over a certain percent of the original home equity. Most lenders stipulate that borrowers who refinance more than 80 percent of their equity must purchase individual mortgage insurance. Along with closing costs, this can significantly take away from savings that might result from the refinance option. It is in the best interest of potential borrowers to examine the amount of savings that would result from a home refinance and to weigh this against other existing debt obligations.  

Reasons for Home Equity Loans

A home equity loan is the better choice for situations in which a homeowner needs extra cash flow for expenses such as college tuition, unexpected medical bills, or existing credit card debt. Refinancing to pay off other debts is not the best option if you have a longer period of time on an existing mortgage; the reason for this is that credit card payments will be stretched over that same time frame. This usually is not the most financially sound option, even with lower payments or interest rates. Unlike refinancing that pays out a lump sum, home equity loans also do not have closing fees that can sometimes significantly subtract from the original amount.

Home equity loans do not come with the associated costs of closing and insurance as is often the case with refinancing. Depending on the percentage calculated from your home value to loan ratio, home equity loan interest amounts up to the first $100,000 are usually tax deductible. A home equity loan is essentially the existing value in the home versus the remaining payment obligation. The higher the value and the lower the obligation, the more practical the option is to apply for a home equity loan instead of refinancing. An exception is cash-out refinancing, which is a more viable option when a home owner has already paid off a large percentage of an existing mortgage. This type of refinancing would pay out the amount of the difference between the old and new rates.